PowerPoint to accompany Chapter 16 Monetary Policy

PowerPoint

to accompany

Chapter 16

Monetary Policy

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

1. Define monetary policy and describe the main goals of monetary policy in Australia.

2. Describe how the Reserve Bank of Australia affects interest rates.

3. Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level.

4. Assess the arguments for and against the independence of the Reserve Bank of Australia.

Learning Objectives


The RBA partly based its decision to increase interest rates between 2005 to 2008 on rising prices. Housing price levels and associated spending were contributing significantly to overall inflation levels.

The economic slow-down that began in 2008 following the global financial crisis led the RBA to rapidly reduce interest rates, to help stimulate slowing housing construction and other spending.

Interest rates affect housing sales and prices


LEARNING OBJECTIVE 1

What is monetary policy?

Monetary policy: The actions the Reserve Bank of Australia takes to manage the availability of cash on the overnight money market and hence interest rates to pursue economic objectives.

The goals of monetary policy.

1. Full employment of the labour force

2. Stability of the Australian currency.

3. Economic prosperity and welfare for the people of Australia.


The goals of monetary policy.

Since 1993 the Reserve Bank of Australia (RBA) has focused monetary policy mainly on achieving price stability.

Inflation targeting: Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

• The RBA’s target inflation rate is between 2% and 3% per annum, on average over the business cycle.


What is monetary policy?

The trend in the rate of inflation, Australia, 1993-2008: Figure 16.1

-1

0

1

2

3

4

5

6

7

Per

cen

t

Source: Reserve Bank of Australia (2009), Statistics, ‘Measure of consumer price inflation’, Table G01, viewed 22 March 2009, at <www.rba.gov.au>. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia



The demand for money.

The demand for money curve is downward sloping to show the inverse relationship between the interest rate on financial assets and the quantity of money demanded.

The interest rate on financial assets is the opportunity cost of holding money.

Low interest rates reduce the opportunity cost of holding money.

High interest rates increase the opportunity cost of holding money.

The demand for and supply of money

Interest rate, i

Quantity of money, M (billions of dollars)

0 $250


7%

The demand for money: Figure 16.2

Money demand, MD

6%

300

1. A decrease in the interest rate …

2. …causes an increase in the

quantity of money demanded.



Shifts in the money demand curve.

Changes in variables other than the interest rate cause the money demand curve to shift.

The two most important variables that shift the money demand curve are:

1. Real GDP.

2. The price level.


Interest rate, i

Quantity of money, M (billions of dollars)

0


Shifts in the money demand curve: Figure 16.3

MD1

A decrease in real GDP or a decrease in the price level will shift money demand to the left.

An increase in real GDP or an increase in the price level will shift money demand

to the right.

MD2

MD3



How the RBA manages the supply of cash.

Chapter 15 review:

Recall: The RBA uses open market operations (OMOs) to sterilise liquidity changes in the financial system, to keep the interest rate the same.

OMOs: The RBA purchasing or selling financial instruments such as Commonwealth Government Securities (CGS) and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements.





Repurchase agreements are widely used by the RBA in its OMOs.

Cash Rate: The interest rate banks, other financial institutions and the RBA charge each other for overnight loans.

The cash rate is determined by the interaction of demand for and supply of funds in the overnight money market.


Turnover in open market operations, Australia, 1998/99 to 2007/08 ($ billions): Table 16.1

Source: Reserve Bank of Australia (2009),Open Market Operations, viewed 30 October 2009, at <www.rba.gov.au>.

1998/99

1999/00

2000/01

2001/02

2002/03

2003/04

2004/05

2005/06

2006/07

2007/08

Repurchase agreements Purchases 300 244 376 423 304 272 391 409 459 297

Sales 13 14 17 16 17 11 10 6 2 1

Outright short-term CGS Purchases 21 9 5 1 3 5 5 4 3 6

Sales 0 0 0 0 0 0 0 0 0 0

Total domestic operations

334 267 398 440 324 287 405 419 464 304





The majority of RBA intervention in financial markets is to sterilise, or offset, daily liquidity deficits and surpluses, to keep interest rates stable.

To change the cash rate, the RBA may not offset an overnight surplus or shortage of funds in the financial system, or the RBA may engage in OMOs to create a shortage or surplus of funds.





A change in the cash rate typically flows through the financial system impacting all

interest rates.


Source: Reserve Bank of Australia (2009), About Monetary Policy, viewed 22 March 2009, at <www.rba.gov.au>.

Short-term interest rates, Australia, 1985-2008 (monthly average): Figure 16.4





Exchange settlement accounts (ESAs): Accounts held with the RBA by banks and other financial institutions to enable the overnight transfer of funds (cash) between financial institutions, and between the RBA and financial institutions.

ESA’s enable real-time gross settlement (RTGS) through the RBA information and transfer system (RITS).

Balances held in ESAs are called exchange settlement funds.





To reduce the cash rate, the RBA publicly announces that it intends to do so.

The RBA will then either:

Not sterilise an overnight surplus, or

Offer to buy back repurchase agreements, or make outright purchases of bonds.

When the RBA pays for the bonds, this increases cash reserves held by financial institutions and the rate of interest will fall.





To increase the cash rate, the RBA publicly announces that it intends to do so.

The RBA will then either:

Not sterilise an overnight shortage, or

Use reverse repurchase agreements or carry out the outright sale of bonds.

When the RBA pays for the bonds, this reduces cash reserves held by financial institutions and the rate of interest will rise.




Equilibrium in the money market.

The RBA will use monetary policy to keep interest rates at its target rate.

Therefore the money supply curve is a horizontal line at the current interest rate.


Interest rate (per cent per

year)

Quantity of money (billions of dollars)

0 $900


7%

Interest rate targeting: Figure 16.5a

MD

Money supply, MS



Equilibrium in the money market.

In the 1970s and 1980s, the RBA used to use monetary targeting.

Monetary targeting: Conducting monetary policy to control the size and rate of growth of the money supply.

Therefore the money supply was exogenously determined by the RBA, and was therefore vertical.

As shown, the RBA no longer uses monetary targeting, but instead uses interest rate targeting.


Interest rate (per cent per

year)

Quantity of money (billions of dollars)

0 $900


7%

Monetary targeting: Figure 16.5b

MD

Money supply, MS1 MS2

950

6%

1. When the RBA increases the money supply from MS1 to MS2 …

2. …the equilibrium interest rate

falls.



The market for loanable funds.

Market for loanable funds: The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds available.

The demand for loanable funds is determined by the willingness of firms to borrow funds to engage in new investment projects.

When deciding whether to borrow funds, firms compare the expected rate of return on their investment with the interest rate (the cost of borrowing).




The supply of loanable funds is determined by the willingness of households to save, and by the extent of government saving or dissaving.

The willingness of households to save rather than consume will depend in part on the interest rate they receive.





Borrowers and lenders are interested in the real rate of interest they will receive or pay.

Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged.



Real interest rate

Loanable funds (dollars per year)

0Equilibrium quantity of

loanable fundsHubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Equilibrium interest

rate

Supply of loanable

funds

The market for loanable funds: Figure 16.6

Demand for loanable

funds


Who was better for economic growth: Scrooge the saver or Scrooge the spender?

Saving makes funds available for firms to borrow for investment.

Ebenezer Scrooge: Accidental promoter of Economic growth?

MAKING THE CONNECTION16.1


Explaining movements in saving, investment and interest rates.

If investment becomes more profitable, eg: due to new technology, there will be an increase in demand for loanable funds.

The demand for loanable funds curve will shift to the right, and interest rates will be lower.

An increase in investment increases the capital stock and the quantity of capital worked per hour, helping to increase economic growth.



Real interest rate


0L1


i1

Supply

An increase in the demand for loanable funds: Figure 16.7

Demand1

D2

1. Technological change increases the demand for loanable funds …

i2

2. … increasing the equilibrium interest rate …

3. … and increasing the equilibrium quantity of loanable funds.

L2


Explaining movements in saving, investment and interest rates.

If the government runs a budget deficit, this reduces the amount of saving in the economy.

The supply of loanable funds curve will shift to the left, and interest rates will be higher.

Higher interest rates may reduce investment (the crowding out effect).



Real interest rate


0L1


i1

Supply1

The effect of a budget deficit on the demand for loanable funds: Figure 16.8

Demand1

1. When the government begins running a budget deficit, the supply of loanable funds is reduced ……

i2

2. … increasing the equilibrium interest rate …

3. … and decreasing the equilibrium quantity of loanable funds.

L2

S2


Does taxing interest earned on savings impact the level of savings?

In the Australian tax system, interest earned on savings is taxed at the individual wage and salary earner’s highest marginal tax rate. Some economists have suggested that interest on savings should be subject to a tax that is no higher than the company tax rate at any given time.

Use the market for loanable funds model to analyse the impact of a policy change of this nature on savings, investment, the interest rate and economic growth.




STEP 1: Review the chapter material. This problem is about applying the market for loanable funds model, so you may want to review the section ‘Explaining movements in saving, investment and interest rates’.

STEP 2: You should also work though Solved Problem 16.1 in the text book.




STEP 3: Explain the effect of taxing interest earned on savings at a rate which does not exceed the current company tax rate. To do this, find the current income and company tax rates on the website of the Australian Tax Office (www.ato.gov.au).

STEP 4: The company tax rate is currently 30% in Australia. Individuals earning $80 000 and over pay a marginal tax rate of 40c for every dollar over $80 000, including interest on their savings (as at January 2010).




STEP 5: If the tax on returns from savings was reduced to equal the company tax rate, then savings from high income earners may increase.

STEP 6: Use the loanable funds model to illustrate this possibility. More savings means the supply curve for loanable funds will shift to the right, the equilibrium interest rate will fall, and the level of savings and investment will both increase. Because investment increases, the capital stock will increase and the quantity of capital per hour worked will grow, and the rate of economic growth should increase.




Monetary policy and economic activity

How interest rates affect aggregate demand.

Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand:

Consumption

Investment

Net exports




The effect of monetary policy on real GDP and the price level.

Over time, potential GDP increases, and the LRAS curve shifts to the right.

The factors shifting the LRAS also shift the SRAS curve to the right, as firms will now be supplying more goods and services.

During most years, aggregate demand also increases, and the curve shifts to the right.





Sometimes, aggregate demand may not increase enough to keep the economy at potential GDP.

Expansionary monetary policy is used during periods of slow growth or contraction.

The RBA may use expansionary monetary policy to increase aggregate demand more than it would have increased without policy.





Expansionary monetary policy: The use of monetary policy by the RBA to decrease interest rates to increase real GDP.

The RBA decreases the cash rate.

This decrease typically flows through to decreases in interest rates through the entire economy.





Lower interest rates may encourage investment, increase net exports, and may increase consumer spending. Real GDP and the price level will rise.

Policy success depends on whether:

1. Interest rate decreases are passed on through the economy.

2. Firms and consumers respond to the lower interest rates; business and consumer confidence.





The dynamic aggregate demand and aggregate supply model is used to illustrate expansionary monetary policy.

Price level

Real GDP (billions of

dollars)

0 $1000


100

SRAS1

Expansionary monetary policy

AD1

LRAS1

AD2(without

policy)

AB

SRAS2

RBA policy causes the AD curve to shift further to the right.

1070

LRAS2

102

1100

103 C

AD3(with policy)


Why Was Monetary Policy Ineffective in Japan?

Despite low interest rates, (real interest rates were zero at times) spending on housing and other types of investment was not high enough to bring the Japanese economy back to potential GDP.






Sometimes, aggregate demand may be increasing too fast, leading to inflation, and the economy may be in equilibrium beyond potential GDP.

Contractionary monetary policy is used during periods of high or rising inflation rates.

The RBA uses contractionary monetary policy to slow the rate of increase of aggregate demand to less than it would have increased without policy.





Contractionary monetary policy: The use of monetary policy by the RBA to increase interest rates to reduce inflation.

The RBA increases the cash rate.

This increase typically flows through to increases in interest rates through the entire economy.





Higher interest rates may reduce new investment, decrease net exports, and may reduce consumer spending. The slower growth in aggregate demand may reduce the inflation rate.

Policy success depends on whether:

1. Interest rate decreases are passed on through the economy.

2. Firms and consumers respond to the higher interest rates.

Price level

Real GDP (billions of

dollars)

0 930


100

SRAS1

AD1

LRAS1

AD3(with

policy)

A C

SRAS2

1000

LRAS2

103

1030

104 B

AD2(without

policy)

Contractionary monetary policy

RBA policy causes the AD curve to shift to the right by less than it would have without policy.





Monetary policy is more effective at reducing the rate of inflation during an economic boom than it is at stimulating aggregate demand during a recession.

Monetary policy is a ‘blunt instrument’ and does not affect all people equally.

Monetary policy is also subject to time lags.


Why Does The Share Market Care about Monetary Policy?

The share market reacts when the RBA implements policy to either raise or lower interest rates.


Expansionary and contractionary monetary policy: A summary: Table 16.2

Reserve Bank Board increases the cash rate

Other interest rates rise

Investment, consumption and net exports decrease

The AD curve shifts to the right by less than it otherwise would have

Real GDP and the price level rise by less than they would have without policy

Reserve Bank Board decreases the cash rate

(a) An expansionary policy

(b) A contractionary policy

Other interest rates fall

Investment, consumption and net exports increase

The AD curve shifts to the right by more than it otherwise would have

Real GDP and the price level rise by more than they would have without policy



The Effects of Monetary Policy on Real GDP and the Price Level.


Suppose you check the RBA website on the first Tuesday of the month, and find the Bank plans to repurchase $100 million worth of financial securities the following day.

What does this policy action suggest to you regarding the current state of the Australian economy?

What impact does the Reserve Bank Board hope this action will have on the real economy?




Solving the problem:

STEP 1: Review the chapter material. The problem is about the role of the RBA and the effects of monetary policy on real GDP and the price level, so you may like to review the section ‘Monetary policy and economic activity’.




Solving the problem:

STEP 2: Answer the first part of the question by explaining that a repurchase of financial securities by the RBA will increase the cash reserves of the banking sector, decreasing the demand for overnight loans between financial institutions and hence the decreasing the cash rate.

In other words, the RBA is conducting an expansionary monetary policy, which suggests growth in the Australian economy is slowing.




STEP 3: The repurchase of financial securities will:

1. Inject funds into ESAs, which will result in a fall in the cash rate.

2. This fall in the cash rate will typically flow through to all interest rates throughout the financial sector.

3. As a result, firms and consumers can borrow and hence spend more.

4. Aggregate demand will then move outwards to the right by more than it would have without policy, GDP will increase, as will the price level.



The case for central bank independence.

Avoids inflationary spending by the government of the day, which may sell bonds to the central bank to finance excessive spending.

Avoids the use of monetary policy to further other political goals. For example, lowering interest rates before an election.

Is the independence of the Reserve Bank of Australia a good idea?



The case against RBA independence.

An independent central bank is not directly accountable to voters, and may implement monetary policy against the wishes of the electorate.

Too much economic power may be concentrated in the hands of a single or small group of non-elected people – those on the RBA Board.

Is the independence of the Reserve Bank of Australia a good idea?


An Inside Look

For inflation fighters, money just doesn’t rate: targeting inflation rather than monetary aggregates.


An Inside LookFigure 1: The inflation rate in Australia has fallen significantly from the levels in the 1970s and 1980s.


Inflation in Australia

1970s 1980s 1990s 1993 - 2006

Inflation rate

(CPI measure)

10.1 8.3 2.3 2.3

Treasury underlying inflation rate

10.1 8.1 2.5 na


Key Terms

Cash rate

Contractionary monetary policy

Exchange settlement accounts

Expansionary monetary policy

Inflation targeting

Monetary policy

Monetary targeting

Open market operations


Get Thinking!

The RBA and the then newly elected Labor Government issued a ‘Statement on the Conduct of Monetary Policy’ in December 2007. Find this document which records the relationship between the Australian Government and the RBA at:

http://www.rba.gov.au

Are there sufficient checks and balances in the Australian system to ensure that monetary policy adequately reflects the will of the Australian electorate?


Check Your Knowledge

Q1. When the interest rate decreases:

a. The money demand curve shifts to the right.

b. The money demand curve shifts to the left.

c. There is a movement downward along a stationary money demand curve.

d. There is a movement upward and to the left along a stationary money demand curve.



Q1. When the interest rate decreases:

a. The money demand curve shifts to the right.

b. The money demand curve shifts to the left.

c. There is a movement downward along a stationary money demand curve.

d. There is a movement upward and to the left along a stationary money demand curve.


Q2. Which of the following determines the supply of loanable funds?

a. The willingness of households and governments to save.

b. The number of financial intermediaries available.

c. Changes in the interest rate, which cause business firms to undertake more or less profitable investment projects.

d. The quantity of stocks and bonds issued by business firms.



Q2. Which of the following determines the supply of loanable funds?

a. The willingness of households and governments to save.

b. The number of financial intermediaries available.

c. Changes in the interest rate, which cause business firms to undertake more or less profitable investment projects.

d. The quantity of stocks and bonds issued by business firms.



Q3. The RBA’s strategy of lowering interest rates in order to increase real GDP is called:

a. Reactionary monetary policy.

b. Contractionary monetary policy.

c. Expansionary monetary policy.

d. Contractionary fiscal policy.



Q3. The RBA’s strategy of lowering interest rates in order to increase real GDP is called:

a. Reactionary monetary policy.

b. Contractionary monetary policy.

c. Expansionary monetary policy.

d. Contractionary fiscal policy.


Documents

PowerPoint to accompany Chapter 16 Monetary Policy